Tellabs, Confidential Witnesses And The Eighth Circuit

The circuit courts continue to evolve their view of the Supreme Court’s test under Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007), construing the PSLRA’s “strong inference” of scienter requirement. Last week, the Ninth Circuit resolved the question of whether inferences of scienter of senior executives can be drawn from the core operations of a company, as discussed here.

The Eighth Circuit recently considered the application of Tellabs in Western Pa. Electrical Employees Benefits Fund v. Ceridian Corp., No. 07-2707 (8th Cir. Sept. 11, 2008). There, the court reviewed a ruling by the district court dismissing a financial fraud complaint. The District Court concluded that plaintiffs had failed to plead a strong inference of scienter as required by Section 21D(b)(2) of the Reform Act as to the individual defendants. The ruling was made prior to the Supreme Court’s decision in Tellabs.

The Eighth Circuit affirmed the district court. The Court began by noting that under Tellabs, the complaint as a whole must be considered to determine whether there is a strong inference of scienter which is at least as cogent as any opposing inference. Although the District Court examined the question of meeting the PSLRA strong inference test by examining each allegation, rather than discussing the complaint as a whole, this was not necessarily inappropriate.

The Circuit Court went on to review each allegation in the complaint which it characterized as a jumble of accounting allegations that were not necessarily related. The Court concluded its review of the District Court’s decision by looking at the allegations collectively as required by Tellabs.

Two points are of interest. First, in a prior ruling applying Tellabs, the Eighth Circuit combined the Supreme Court’s equipoise test with its prior jurisprudence with the Second Circuit motive and opportunity test. Crowell v. Possis Medical, Inc., No. 07-1840 (8th Cir. Mar. 21, 2008). In Ceridian however, the Circuit Court did not discuss the “motive and opportunity test.”

Second, in analyzing the plaintiffs’ allegations, the Court considered those from confidential witnesses. Those allegations identified the job title of the witness and provide some detail about the prior position. In reviewing those allegations however, the Court assumed that the use of information from confidential sources is appropriate under the Reform Act without discussion. Other circuit courts have found allegations from confidential witnesses adequate under the Reform Act requirement that “all facts” must be pled only if certain conditions are met. Compare, Makor Issues & Rights, Ltd. v. Tellabs, Inc., 513 F.3d 702 (7th Cir. 2008) (requiring sufficient detail to evaluate the information) with Higginbotham v. Baxter International, Inc., 495 F.3d 753 (7th Cir. 2007) (rejecting the use of such witnesses were there was insufficient information about the person).

CSX Affirmed And New Financial Fraud And Options Backdating Cases

The Second Circuit summarily affirmed the CSX ruling in a case which raises significant issues regarding whether the present regulatory scheme is outmoded – a point being raised by many in view of the collapse of Lehman Brothers, the take-over of Merrill Lynch and other market events on Monday. In addition, the SEC filed actions involving financial fraud and options backdating.

CSX: The Second Circuit Court of Appeals affirmed the decision of Judge Kaplan not to enter an injunction in CSX v. Children’s Investment Fund, No. 08-2899-cv (2nd Cir. Sept. 15, 2008). That case centered on a bitter proxy contest. CSX claimed defendants, who held an interest in CSX stock through various contractual arrangements, failed to comply with the disclosure requirements of Section 13(d). As discussed more fully here, the court found violations of Section 13(d), but under existing precedent declined to enter an injunction which would preclude voting the shares. Underlying the case is a question of whether Wall Street innovations such as the synthetic securities held by defendants have outstripped present regulation.

Financial fraud: In SEC v. American Italian Pasta Company, Case No. 4:08-cv-00675 (W.D. Mo. filed Sept. 15, 2008), the Commission filed a financial fraud case against the company in tandem with separate actions against three of its officers and two criminal cases filed by the U.S. Attorney’s Office. The Commission brought actions against AIPC’s former chief executive officer Timothy S. Webster, former CFO Warren B. Schmidgall and former executive vice president of corporate development and strategy David E. Watson. The SEC alleged that the defendants engaged in a scheme to defraud beginning in the middle of 2002 after an earnings shortfall. In response to that shortfall, the Commission claims that the defendants held a “Profit Achievement Task Force” and other meetings focused on closing the earnings gap. At these meetings, the executives committed to closing the gap between net income reported and the Wall Street consensus. This, the complaint notes, resulted in a culture of fraudulent accounting.

As a result of the tone set at the top, the SEC claims the defendants engaged in a number of fraudulent accounting practices including:

• The fraudulent capitalization of manufacturing costs;

• The fraudulent capitalization of certain expenses;

• The improper reduction of depreciation expenses;

• The improper capitalization of certain costs;

• Failing to reduce the value of its spare parts inventory as required; and

• Engaging in improper round-tripping of cash transactions.

As a result of these and other practices, the company overstated its pre-tax income by more that $36 million and its EPS by about 23% for fiscal 2002, 42% for fiscal 2003 and 59% in the first quarter of fiscal 2004. In June 2008, the company restated its financial statements.

To resolve the Commission’s case the company and Messrs. Webster and Ruskey consented to the entry of permanent injunctions prohibiting future violations of the antifraud and reporting provisions. In addition, Mr. Webster consented to the entry of an order requiring the payment of disgorgement of about $750,000 plus prejudgment interest, a civil penalty of $250,000 and barring him from serving as an officer or director of a public company. Mr. Ruskey also consented to the entry of an order requiring that he pay a civil penalty of $25,000.

In the related criminal cases, Messrs. Webster and Schmidgall pled guilty to one count of conspiracy to commit wire fraud. U.S. v. Webster, 08-00259-01-Cr-W-DGK (W.D. Mo.); U.S. v. Schmidgall, No. 08-00260-01-Cr-W-DW (W.D. Mo.). The company agreed to resolve the criminal investigation by paying a $7.5 million penalty.

Option backdating: The Commission also filed another settled options backdating case, SEC v. Karatz, Civil Action No. CV 08-06012 (C.D. CA. Filed Sept. 15, 2008). This action, filed against former chairman and CEO of KB Home, Inc., alleged that the defendant engaged in a multi-year scheme to backdate stock options for himself and others at the company. According to the complaint, from 1999 through 2005 Mr. Karatz used hindsight to pick advantageous grant dates for company stock option grants. As a result Mr. Karatz received a total of 2,860,000 shares of KB Home stock and made more than $6 million from the exercise of the options.

To resolve the case, Mr. Karatz consented to the entry of a permanent injunction prohibiting future violations of the antifraud, reporting and proxy provisions of the federal securities laws. In addition, Mr. Karatz agreed to the entry of an order requiring him to pay approximately $6.7 million in disgorgement and interest and a civil penalty of $480,000. That order also bars him from serving as an officer or director of a public company for five years.